Table Of ContentThe Intelligent
Asset Allocator
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The Intelligent
Asset Allocator
How to Build Your Portfolio
to Maximize Returns and Minimize Risk
William J. Bernstein
McGraw-Hill
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Contents
Preface vii
Introduction xiii
1. General Considerations 1
2. Risk and Return 9
3. The Behavior of Multiple-Asset Portfolios 29
4. The Behavior of Real-World Portfolios 41
5. Optimal Asset Allocations 63
6. Market Efficiency 85
7. Odds and Ends 111
8. Implementing Your Asset Allocation Strategy 143
9. Investment Resources 175
Appendix A: Becoming Your Own Portfolio Analyst 181
Appendix B: Correlation Coefficients Among Asset Classes 183
Glossary 187
Bibliography 195
Index 199
v
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Preface
On July 31, 1993, I came across an article in The Wall Street Journal
(“Your Money Matters” series) which examined the performance of
various asset allocations for the period 1973–92. The article was
based on research done at the T. Rowe Price mutual fund group.
The technique used was quite simple: imaginary portfolios were
constructed from various combinations of U.S. large and small
stocks, foreign stocks, and U.S. bonds, and returns and risks were
calculated. The article pointed out that over the 20-year period stud-
ied various fixed mixes of the above assets outperformed the single
component parts (as well as most professional money managers),
with significantly lower risk. I was intrigued. T. Rowe Price kindly
sent me the data underlying their calculations, which I analyzed. The
results were astonishing—almost any reasonably balanced fixed
combination of the four assets outperformed most professional
money managers over the same period.
For example, a “simpleton’s portfolio” consisting of one quarter
each U.S. large stocks, U.S. small stocks, foreign stocks, and U.S.
high-quality bonds had a higher return, with much lower risk, than
large U.S. stocks alone (represented by the S&P 500 index). The S&P
500, in turn, performed better than 75% of professional money man-
agers over the same period.
I was fascinated by the T. Rowe Price data; here was a simple tool
for ascertaining historical asset allocation performance—collect data
on the prior performance of various asset classes, and “backtest”
returns and risks. To my disappointment, I could find no readily
available software which accomplished this; I would have to write
my own spreadsheet files. I began to buy, beg, steal or borrow data
on a wide variety of assets over several different historical epochs
and build portfolio models going back as far as 1926.
The calculations performed by T. Rowe Price and myself con-
tained an important implicit assumption: that the portfolios were
vii
viii Preface
“rebalanced” periodically. Rebalancing becomes necessary after a
while because some assets in a portfolio will do better than others,
and this will alter the original portfolio composition. In order to
rebalance the portfolio back to its starting composition, some of the
better performing assets must be sold—and the proceeds used to
purchase more of the poorly performing assets.
Most experienced investors learn that the key to long-term success
lies in a coherent strategy for allocation among broad categories of
assets, principally foreign and domestic stocks and bonds. They also
understand that market timing and stock or mutual fund picking are
nearly impossible long term. They are at best a distraction. Put
another way, it is far more important to come up with the right pro-
portion of foreign stocks, U.S. stocks, foreign bonds, and U.S. bonds
than it is to pick the “best” stocks or mutual funds or to “call” the
tops or bottoms of the markets. (As we shall see later, nobody con-
sistently calls the market, and almost nobody picks stocks or mutu-
al funds with any persistent skill).
If you find this difficult to believe, consider the following: 1987
was not a great year for the U.S. stock market. U.S. large company
stocks (represented by the S&P 500) gained only 5.23% that turbu-
lent year, and small company stocks actually lost 9.3%. On the other
hand, foreign stocks gained 24.93%. The clumsiest foreign fund
manager would have beaten the most skillful small-stock picker that
year. In 1992, the opposite would have occurred when U.S. small
stocks gained 23.35% and foreign stocks lost 11.85%. Finally, the
1995–1998 period provided unprecedented returns for the biggest
U.S. growth stocks but battered almost everything else.
Still not convinced? In the late 1980s, Gary Brinson, a noted
money manager and financial analyst, and his colleagues published
two sophisticated statistical studies of 82 large pension funds. They
concluded that asset allocation accounted for over 90% of the return
variability among the funds, with a less-than-10% contribution from
market timing and actual stock and bond selection. In other words,
asset allocation policy was 10 times as important as stock picking
and market timing combined. In recent years many observers have
suggested that the 90% figure is too high; perhaps asset allocation
accounts for only 50% of return variability. Such arguments com-
pletely miss the point. Market timing and security selection are obvi-
ously important. The only problem is that nobody achieves
Preface ix
long-term success in the former, and almost nobody in the latter.
Asset allocation is the only factor affecting your investments that you
can actually influence.
It is thus truly astonishing that so much ink and airtime is wasted
on analysts’ predictions of the direction of stock or bond prices and
on particular stock and mutual fund recommendations. In fact, when
Mr. Brinson himself appeared on Louis Rukeyser’s Wall Street Week
in 1994 almost all of his comments were directed toward market tim-
ing and almost no attention paid to asset allocation strategy. The
gambling instinct is ingrained in human nature, and few can resist
speculation on events that cannot be foreseen.
So how do you arrive at the allocation that will provide the most
return with the least amount of risk? You can’t. But don’t feel bad,
because neither can anyone else. Not even Mr. Brinson, who until he
retired had more assets under management than any other individual
on the planet. Sure, you can look at historical data and examine what
has worked in the past, but don’t confuse that with what will work in
the future. Later we shall look at historical data and attempt to extract
from it useful portfolio advice, but the lessons are sparse. First, stocks
are riskier than cash. Second, in the future they will probably have
higher returns than cash, but not by as much as in the past, particu-
larly the recent past. Third, portfolio diversification reduces risk. And
last, index your investments wherever you can.
In fact, if you tire of reading this book and simply want a recipe
for a serviceable portfolio, consider the following advice: Purchase
the above-mentioned “simpleton’s portfolio” consisting of index
funds—one quarter each of U.S. large and small stocks, foreign
stocks, and a short-term U.S. bond fund. Index funds have become
almost as commoditized as computer chips and gasoline, and they
are available through most large fund families and “supermarkets.” I
highly recommend Vanguard. At the end of each year, rebalance your
accounts so that each of the four parts are again of equal size. That’s
it. Setting up the account should take about 15 minutes, and the
annual rebalancing should also take about 15 minutes. You can for-
get about investing for the rest of the year. If the next 20 years are
anything like the last 20, then you will outperform the portfolios of
75% of all professional money managers.
In 1996, I placed this book’s first edition on-line and began
writing regular pieces for my website, Efficient Frontier
